An average earnings scheme is a pension arrangement in which retirement benefits are calculated from average earnings over part or all of a worker’s career rather than only from final salary.
Why the design matters
Using average earnings usually spreads benefits more evenly across a career and reduces the heavy dependence on earnings near retirement. That can make pension costs more predictable and reduce the strong back-loading often seen in final-salary plans.
Economic implications
Compared with a final-salary formula, an average-earnings scheme typically:
- lowers sensitivity to late-career wage jumps,
- changes retirement and tenure incentives,
- affects redistribution across workers with different wage paths.
That is why economists treat pension design as part of labor-market incentives, not just retirement administration.
Related Terms
Knowledge Check
### An average earnings scheme bases benefits on:
- [x] earnings averaged over a period of the worker's career
- [ ] only salary in the final year
- [ ] only employer profits
- [ ] only current inflation
> **Explanation:** The defining feature is averaging earnings rather than relying solely on final pay.
### Why might this design reduce volatility in pension costs?
- [x] Because benefits are less tied to late-career salary spikes
- [ ] Because earnings no longer matter
- [ ] Because pension promises disappear
- [ ] Because annuities are not needed
> **Explanation:** Averaging smooths the effect of short-lived high earnings near retirement.
### Compared with final-salary schemes, average earnings schemes often:
- [x] weaken some back-loaded incentives to stay until the very end of a career
- [ ] make retirement decisions irrelevant
- [ ] eliminate accrual formulas
- [ ] guarantee higher benefits for every worker
> **Explanation:** The benefit path changes, so labor-supply and retention incentives change too.